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Asset Protection Planning with Limited Liability Companies

When
consulting with a client regarding forming a limited liability
company (LLC) for business and tax reasons, it is common to
address the issue of asset protection. The basic objective of
asset protection engagements is to transfer assets to reduce
or eliminate any exposure to liabilities in conjunction with
the client’s estate plan or other financial concerns. Care
must be taken to avoid transfers specifically to avoid
creditors, which can be considered fraudulent.

Practitioners
often are in an excellent position to identify the need for an
asset protection strategy and recommend possible methods of
implementation. For example, suggesting the formation of an
LLC before a client acquires a parcel of commercial real
estate may protect the client from liability exposure. The
practitioner may also suggest that the client restructure his
or her existing holdings to protect assets.

Caution: Restructuring a client’s existing
asset holdings for asset protection purposes has many legal
implications that must be considered with the assistance of an
experienced attorney. In general, a transfer of assets to an
LLC protects the assets from the LLC member’s creditors.
However, a member’s creditors can obtain a charging order
against the member’s interest and become entitled to receive
any profits, losses, and distributions to which the member
would otherwise be entitled. The creditor does not, however,
have the right to participate in LLC management, including the
right to force a distribution. This may put the creditor in a
difficult position, since he or she may be allocated the
debtor member’s share of LLC taxable income but receive no
distribution to pay the income taxes due on that income.

Fraudulent
Transfers

Any
asset protection plan must consider the possible application
of fraudulent transfer laws. The purpose of these laws is to
prevent debtors from transferring assets for the primary
purpose of defrauding creditors. If a court determines an
asset transfer to be fraudulent, the transfer will be voided,
exposing the asset to a creditor’s claim.

Fraudulent
transfer laws vary from state to state and are also addressed
in the U.S. Bankruptcy Code and the Internal Revenue Code.
Three common questions considered by most jurisdictions when
applying fraudulent transfer laws are:

Did the
transferor intend to hinder, delay, or defraud a creditor
at the time the transfer was made?

Was the
transferor solvent at the time of the transfer?

Was the transfer made in exchange for reasonably
equivalent consideration?

While
formulating asset protection plans that involve the transfer
of assets, practitioners must objectively consider a possible
challenge from the point of view of the client’s creditors.
The business purpose for the transfer should be documented in
order to prove that the transferor did not intend (actually or
constructively) to defraud a creditor. The evaluation of the
transferor’s intent is based on the facts and circumstances at
the time of the transfer. Though fraudulent transfer laws vary
from one jurisdiction to another, indications of fraudulent
intent (commonly called badges of fraud) include:

Retaining control
or possession of the transferred property;

Concealing the transfer;

Transferring
assets after litigation began or under the threat of
litigation;

Transferring substantially all the
client’s assets;

Receiving inadequate
consideration from the transferee; and

Transferring assets in an amount that results in the
transferor’s insolvency at the time of the transfer or
shortly thereafter.

Practitioners should
prepare a detailed solvency analysis at the outset of an asset
protection engagement to document their client’s financial
position prior to any asset transfer. This is an important
step because the transferor’s insolvency at the time of an
asset transfer (or shortly thereafter) is an important
indication of fraudulent intent. The Uniform Fraudulent
Transfer Act (UFTA) and the Uniform Fraudulent Conveyance Act
(UFCA) provide similar definitions of insolvency.

Both
acts consider transferors insolvent if their debts exceed the
fair market value of their assets and exclude any assets that
are exempt from creditor claims when determining solvency.
Under the UFTA, a debtor is presumed to be insolvent if he or
she cannot pay debts as they become due. Both acts take into
account contingent liabilities; however, the UFCA considers
them at face value. Under the UFTA, contingent liabilities are
considered at the amount they are most likely to be settled
for. The UFTA provision generally benefits debtors. However,
due to a lack of guidance, care must be taken to document the
calculation of the discounted liabilities.

Caution: A practitioner who recommends a
fraudulent transfer may be subject to legal sanctions and/or
may be in violation of professional ethics. Practitioners
should not engage in formulating asset protection plans unless
they have sufficient knowledge of the underlying law. In
addition, an attorney with experience in this area should be
consulted.

Principal Residence Protection

From an asset protection standpoint, the use of an LLC to hold a
personal residence may provide liability protection that is
superior to the typical tenant by the entirety title generally
used by married individuals to own a personal residence. A
single person would clearly have additional protection when
compared to individual ownership.

Basic estate planning for
married individuals generally requires the segregation of
assets in order to maximize the use of each person’s unified
credit amount. The use of an LLC makes it easier to fragment
ownership of a personal residence without increasing exposure
to possible liabilities.

While it appears that the use
of an LLC to hold a personal residence may offer a variety of
advantages to the property owner or owners, it is important to
note that the IRS has taken a position that the period of time
a personal residence is held by a partnership (including an
LLC) will not qualify as a personal period of ownership under
the gain exclusion rules of Sec. 121 (Letter Ruling 200119014,
revoking Letter Ruling 200004022). Accordingly, practitioners
should analyze the owners’ tax positions carefully before
putting a personal residence into a multimember LLC.

Alaska and Delaware Trusts

Alaska and Delaware
provide a domestic alternative to offshore asset protection.
(Many other states have similar provisions.) The Alaska asset
protection trust can provide distributions to the grantor (as a
beneficiary) at the discretion of the trustee without exposing
the trust to claims of the grantor’s creditors. The Delaware law
extends spendthrift protection to an irrevocable trust of which
the grantor remains a discretionary beneficiary, as long as the
trustee is neither the grantor nor a related or subordinate
party.

The Alaska Trust Act does not prevent a creditor from
voiding a transfer to an asset protection trust on grounds of
fraud. However, it does provide substantial protection from
the claims of certain of the grantor’s creditors. This level
of protection for self-settled trusts is rare in the United
States. (In addition to providing asset protection, the Alaska
statute enables individuals to make completed gifts for estate
tax purposes while remaining an eligible beneficiary of the
trust.)

Enforcement Issues Involving Alaska and Delaware
Trusts

While Alaska and Delaware trusts provide better
protection than trusts governed by the laws of other states
without similar provisions, several significant enforcement
issues may arise.

Generally, the Full Faith and Credit Clause
of the U.S. Constitution requires state courts to recognize
judgments of courts in other states. Accordingly, a plaintiff
seeking to set aside a transfer to an Alaska trust may be able
to sue in a creditor- friendly state. Once a judgment is
obtained, it can be brought before an Alaska court for
enforcement purposes only; the merits of the case would not be
retried.

Observation: Generally, the law governing
the trust (i.e., Alaska law in the case of an Alaska trust) is
applied in litigation involving the trust, even if the dispute
is being tried in another state. Accordingly, advocates of
using such trusts argue that state laws will protect trust
assets even if disputes are being tried in other states.
However, there are exceptions to the general rule that a court
must apply the law governing the trust. One such exception
occurs when the law governing the trust violates the public
policy of the state in which the litigation is taking place.
Most states have laws expressly invalidating self-settled
spendthrift trust provisions. In many states, it seems that
courts would have little problem ignoring the Alaska and
Delaware-type self-settled spendthrift trust laws as contrary
to public policy.

Alaska and Delaware trusts also must
contend with constitutional issues arising under the Supremacy
Clause, which generally provides that state statutes that
contradict a federal law are not valid. For example, a
(federal) bankruptcy court will likely try to attach assets
held in one of these types of trusts. In addition, other state
laws (such as the Uniform Enforcement of Foreign Judgments
Act) may contradict the trust statutes, raising questions
about whether the trust statutes will be enforced.

Delaware Series Partnerships and LLCs

Delaware and
many other states allow for the creation of “series limited
partnerships” (SLP). These rules also apply to LLCs classified
as partnerships. This type of partnership or LLC can designate
separate series (or divisions) within the entity into which
assets and ownership interests can be segregated (Del. Code
§§17-218(a), 18-215(a)). The SLP can be structured to take
advantage of the segregation possibilities under the statute—
allowing each series to stand alone as a separate entity. Each
series within the series partnership or LLC can have its own
business or investment purpose, classes of ownership interest,
and liability limitations.

Originally, these provisions were
intended to allow the creation of multiple hedge funds or
similar investment fund series within a single state law
entity. However, SLPs may be used for any type of
business—real estate interests, operating business, or any
other assets. Although an SLP is considered a single legal
entity for state purposes, the federal income tax treatment is
a gray area.

In its first ruling on the treatment of
series LLCs (Letter Ruling 200803004), the IRS indicated that
a separate series in an LLC with more than one owner will be
treated as a separate partnership if the election to be
classified as a corporation is not made. A separate series
with one owner is taxed as a disregarded entity.

It is
important to note that the ruling in this case was based on a
structure with the following proposed operation:

Each LLC series
will consist of a separate pool of assets, liabilities, and
stream of earnings.

The shareholders of an LLC
series may share in the income only of that LLC series.

The ownership interest of the shareholders of an
LLC series will be limited to the assets of that LLC series
upon redemption, liquidation, or termination of that LLC
series.

The payment of the expenses, charges,
and liabilities of an LLC series will be limited to that LLC
series’ assets.

The creditors of an LLC series
are limited to the assets of that LLC series for recovery of
expenses, charges, and liabilities.

Each LLC
series will have its own investment objectives, policies,
and restrictions.

Votes of shareholders may be
conducted by each LLC series separately with respect to
matters that affect only that particular LLC series.

The shares of each LLC series are not, and will not be,
traded on an established securities market or regularly
quoted by any person, such as a broker or dealer, making a
market in the shares.

No person regularly
makes available, and will not make available, to the public
(including customers or subscribers) bid or offer quotes
with respect to the shares or stands ready, or will stand
ready, to effect buy or sell transactions at the quoted
prices for itself or on behalf of others.

No
shareholder has, or will have, a readily available, regular,
and ongoing opportunity to sell or exchange the shares
through a public means of obtaining or providing information
of offers to buy, sell, or exchange shares.

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